savings scheme interest rate: Why the economy needs a low interest rate regime – The Economic Times

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SynopsisFor credit markets to revive again and for lending to expand as needed, we need a low interest rate regime. This cycle will peak and correct as it always does, but right now we are closer to the bottom than the top.

Interest rates on government savings schemes were slashed during the routine process of revision and reset last week, only to be rolled back. There were murmurs about how lowering rates hurts investors. But how we got here is a long story worth thinking about. In my early days of observing market data, I recall the long schedule of interest rates that the RBI published. Rates for term loans by the development finance institutions, for banks and loans under every category such as priority lending and export finance were specified. The money market meant the inter-bank call rate was fixed at 10%. The interest rate schedule was filled with double digit numbers, and one recalls a 22% rate and an inflation number of 19%. If someone told me that these numbers would be low single digits in my lifetime, I would have then been incredulous.

Those were the mid 1980s when students of economics read reports of various committees that made policy recommendations. The Tandon and Chore committees on working capital directed how current assets and liabilities must be valued and how maximum permissible bank finance (MPBF) was to be arrived at. We lived through times when banks were told how much they could lend and at what rates. There was no home loans as banks did not lend against immovable assets. The only vehicle loans were for autos and taxis marked with the words “Hypothecated to xyz Bank”. Only businesses got bank loans.

The government in those days routinely ran a budget deficit. It simply relied on banks to fund the deficit. The SLR was 38.5% and the CRR was 15%. Over 50% of a bank’s deposits were subverted by the government. There was just not enough money to lend to businesses. The government borrowings were through government securities issued at a rate suggested by RBI and accepted by banks; 91-day T bills were issued on tap at a fixed rate of 4.75% unchanged since 1975; currency notes were printed with impunity when all else failed. No one cared as long as the government got what it needed.

There was no money market. Shrewd businesses used the Unit Scheme 1964 as their treasury product. This scheme of the UTI announced sale and repurchase prices regularly and offered a decent dividend. Income and liquidity thus assured, this was a preferred parking space. The various government sponsored saving schemes run by the post offices were the preferred investment avenues of the retired public. All of these schemes offered double digit interest rates, mostly fixed arbitrarily by the government.

We should remember that none of this ended well for the economy. The lack of credit held us back terribly; it also created various opportunities for subverting the limited credit to privileged groups. It was not easy for a household to borrow. Nor was it easy to set up a small business and use loan and leverage to reduce the cost of capital. Many established businesses tapped the retail markets by offering deposits, but these created many waves of fraud and depositors lost money to unscrupulous elements.

The modern financial markets as we now know came about only after the 1990s. Recommendations of the Narasimham Committee led to many profound reforms including the reduction of SLR to 25% and the setting up of banks in the private sector. The government decided to borrow at market rates to fund its deficits. Money markets were created (Vaghul Committee) and we now have Tbills, commercial paper and a thriving repo market for overnight funds.

“The modern financial markets as we now know came about only after the 1990s. The recommendations of the Narasimham Committee led to profound reforms including the reduction of SLR to 25% and the setting up of banks in the private sector.”

— Uma ShashikantThe government’s decision to borrow from the market was significant. RBI conducted auctions, stopped funding the deficit from its books, and bank treasuries became active investors in the G-sec markets. Money markets grew rapidly and RBI was soon announcing only the repo rates. Every other rate in the economy was now market determined. Except the rates on government saving schemes and the provident fund.

These two remained holy cows. The problem with the savings schemes of the Post Office was that it had nefariously become the official white washing arena for black money, though no one officially would admit it. Indira Vikas Patra was a consummate symbol of what was wrong with these schemes.

So we had the same government borrowing at the market, for 15 years, at 8.5% and offering 12% interest on its own 15-year product, the PPF. This distorted the yield curve and also encouraged flow of funds into saving schemes at an artificially high rate. Investors remained tied to privileged rates offered by the government and any attempt to introduce market rates into these products failed. The PF was even worse. Trade unions arm twisted the government to use budgetary funding to make good any shortfall in the “promised” interest rates.

The factor that enabled investors to appreciate market rates was retail lending. In the early 2000s banks were unshackled from the restrictions to lend to the retail sector. Home loans boomed as a product; car and commercial loans that were the forte of NBFCs moved to the banking sector; credit card and personal loans took off. Early borrowers will recall home loan rates of 15-18% from private lenders in the NBFC sector in the 1990s. By 2004, home loans were available at 8%.

The period of low interest rates that ensued has kept the economy healthy and growing at a fast clip, primarily because low interest rates enable businesses to invest and expand; they spur demand as consumers have more to spend and are willing to borrow. The last 20 years is truly the story of the benefits of the market oriented economy, and the credit expansion that the low interest rate regime unleashed. We now have a low single digit inflation number as it should be.

The government finally accepted the recommendations of the Shyamala Gopinath Committee and agreed to link all saving scheme rates to the market. These schemes were reduced in number, and streamlined to control abuse. And thus we have arrived at a periodical revision of these rates in line with the markets as it should be. Interest rates are what a free market offers. They are no one’s privilege.

We are in a place where banks suffer a deeply leveraged balance sheet with poor quality asset holdings. For credit markets to revive again and for lending to expand as needed, we need a low interest rate regime. This cycle will peak and correct as it always does, but right now we are closer to the bottom than the top.

(The writer is Chairperson, Centre for Investment Education and Learning)

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